Protecting What Is Best for Investors

Putting client interests first may seem like a simple concept, but it’s causing an uproar on Wall Street.”  Barlyn, S. (2010, Dec. 5). What’s No. 1 for Brokers? The Wall Street Journa.l

Suitability vs. Fiduciary

Understanding the difference between fiduciary and suitability is important for clients for many reasons. Both words, their definitions and the standards they require of those in the financial services industry, tell us much about both the industry and standard your advisor is required to follow when giving you financial advice.

Two Distinctly Different Standards for Clients

“Brokers are typically paid through commissions, which can complicate the relationship. Also, brokerage firms may earn fees from investment companies for promoting their products, such as certain mutual funds.”

Barlyn, S. (2010, Dec. 5). What’s No. 1 for Brokers? The Wall Street Journal.

BROKER/ Registered Representative (the Suitability Standard):

  • Offers products for sale from a range of products provided or marketed by the company or companies they represent
  • Is paid commissions calculated as a percentage of the amount of money invested into the product and is paid a new commission each time money is moved from one product, or mutual fund, to another

ADVISOR/ Financial Advisor (the Fiduciary Standard):

  • Offers “best advice,” taking into account the needs of each individual client and discloses conflicts of interest.
  • Is paid a quarterly fee calculated as a percentage of the assets under advisement.

A Speech by SEC Staff: Fiduciary Duty

On Feb. 27, 2006, at the Eighth Annual Investment Adviser Compliance Summit in Washington, D.C., Lori A. Richards, director of Office of Compliance Inspections and Examinations for the U.S Securities and Exchange Commissions, states in her speech “A Speech by SEC Staff: Fiduciary Duty: Return to First Principles” that an advisor, as that trustworthy fiduciary, has five major responsibilities when it comes to clients. They are:

  1. to put clients’ interests first
  2. to act with utmost good faith
  3. to provide full and fair disclosure of all material facts
  4. not to mislead clients
  5. to expose all conflicts of interest to clients

However, as much as 90 percent of the financial services industry operates outside of this fiduciary standard, meaning they have a suitability standard and are paid a commission, which is proportionate to the initial amount of money deposited into the products they recommend. The commission is not related to the success or failure that the client ultimately achieves with those products.

“After all, brokers are ultimately salespeople who are generally compensated by commission and whose primary loyalty is to their employers. As a result, regulators have never required brokers to act as fiduciaries — that is, to act in the undiluted best interest of their customers.”
Ody, E. (2010, December). Whose Investment Advice Can You Trust? Kiplingers Personal Finance.

In contrast, the fiduciary standard, held by “investment advisors,” is one in which you are paying for advice that by law is required to be in the unbiased best interests of the client. In return for this advice, clients usually pay a fee for the advice or pay a percentage of the assets that are managed by the advisor. The advisor’s income is NOT based on which investments he/she directs you toward; it is based on the total amount of assets upon which advice is provided. Should your assets increase, so too will the amount being received by the advisor — you and the advice provider are impacted financially by the failure or success of your investments. The fiduciary advisor is also required by law to disclose any conflicts of interests.

Where is the Conflict?

In 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. It is estimated that between 2000 and 2010, Wall Street firms have paid the Securities and Exchange Commission over $26 billion in fines. Although this is a large sum of money, it only represents a fraction of the profits reported by these firms. Further, the fines were able to be paid without requiring an admission of wrongdoing.

Why is this Important?

The suitability standard requires that a broker need check the suitability of a prospective buyer — based primarily upon the following financial objectives: current income level and age — in order to complete a commissionable sale of a financial product.

When searching for an independent fiduciary advisor, here are a few areas that should be carefully reviewed:

  • Confirm that the advisor is registered with the state or the SEC as a “Registered Investment Advisor” or is an Investment Advisor Representative (IAR) of a Registered Investment Advisor (RIA).
  • Confirm that the advisor uses a reputable well known third-party, custodian, which offers anytime online account access and monthly statements that are sent directly to each account holder. Please contact us for recommendations.
  • Ask if the Registered Investment Advisor firm conforms to the Global Investment Performance Standard (GIPS) governed by the CFA Institute. This highest of voluntary standards is followed in more than 34 countries by companies that desire to adhere to the fundamental principles of full disclosure and fair representation of investment performance results. Global standardization of investment performance reporting gives investors around the world the additional transparency they need to compare and evaluate investment
  • Determine how your advisor is compensated. Is it through commissions from selling mutual funds, or is it based on a percentage of the assets under their management? Demand fee-only and request to see the fee in writing.
  • Ensure that your advisor does not receive commissions for trading stocks or bonds.
  • Does the advisor’s firm also manage money for large institutional clients? Why is this important? The level of due diligence completed by the experienced investment committees and the legal teams of institutional investors is extensive, exhaustive and ongoing. As an individual investor, this level of procedural oversight and added scrutiny is a benefit to you, as the large institutional investors keep an eye on the investment firm.

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What is Third-Party Custodianship?

Definition of Custodian:
A financial institution that holds customers’ securities for safekeeping so as to minimize the risk of their theft or loss. A custodian holds securities and other assets in electronic or physical form. Since they are responsible for the safety of assets and securities that may be worth hundreds of millions or even billions of dollars, custodians generally tend to be large and reputable firms.
Investopedia, July 2013

Investors can avoid allowing their dollars to be used for collateral for the broker-dealer’s trading by using a third-party custodian to hold your investments. Here is an example of how it works: if you hire a financial advisor with a fiduciary responsibility to you — the investor — you are paying the advisor for his or her investment advice. The funds he or she manages for you will then be held with a third-party custodian, such as Fidelity. The advisor will have the ability to manage your account but never withdraw, move the funds or use your assets as collateral. You have control to “fire” the advisor at any point, and the third-party custodian will still hold your account. You will have online access to your account via the third-party custodian’s website, and statements will be generated and sent directly to you by the custodian — thereby ensuring you are receiving accurate account values. As you can see, this arrangement keeps you in control and removes inherent conflicts.

Building your own retirement income

“To maintain living standards into old age we need roughly 20 times our annual income in financial wealth. If you earn $100,000 at retirement, you need about $2 million beyond what you will receive from Social Security. This number is startling in light of the stone-cold fact that most people aged 50 to 64 have nothing or next to nothing in retirement accounts and thus will rely solely on Social Security.”

Ghilarducci, T. (2012, July 21). Our Ridiculous Approach to Retirement. The New York Times.